Cocorico dependent

France is currently drawing a lot of worldwide attention from both sports commentators, with the entry of the “onze de France” into the Euro foot tonight and the incoming Olympic games in Paris, and investors with French political uncertainties weighing on sentiment after French President Macron called a snap election. As a result, European equity markets ended sharply lower last week, dragged down by the CAC 40 (-6.2%), while peripheral spreads with Germany widened quite substantially (about +30bps over the week). For France, it was the largest weekly increase since the Euro crisis, bringing the differential to circa 75bps this morning. That’s the highest level since November 2012, while for Italy, Greece, Spain or Portugal, spreads are basically back to end of last year levels. In order to keep a cool head and thus avoid overreacting, let’s review the possible outcomes of this snap French election, and their implications in terms of risks and opportunities while also taking into account the global picture.  

Selected Euro Area peripheral 10y government bond’s spreads with Germany: French market currently in the eye of the storm with the rest of Europe being sucked into the vortex

The only thing you can be sure of is that… this French political uncertainty will be with us until at least the 2nd round of the election on July 7th. The polls are indeed showing the far right and left outpacing the President’s centrist party with vote intentions of about 45%, 35% and 20% respectively and still many moving parts in terms of possible alliances between political parties before or after the 1st round, key role of voters’ turnout and some idiosyncratic voting dynamics as legislative elections are at the local level. Note that we will also get UK general election in between the two rounds, on July 4th, to add to the political noise on the markets. Against this backdrop, what are the plausible outcomes and their (non-exhaustive) implications?

1. A hung parliament with a far-right (or a left) relative majority: no single political party or pre-existing coalition has an absolute majority of legislators (likely the most probable outcome in my opinion to date). At this stage, depending on the forces at play, there will be three government options: minority far-right government, central coalition government coalition, left-minority government 

  • Political deadlock, limited economic implications, no major economic or fiscal reforms passed and thus little risk of a significant fiscal slippage of France, with perhaps a slower improvement in the fiscal balance than previously expected.
  • French risk premium will remain around current levels with OAT sovereign bonds spreads trading in a 60-100bps range, while other peripheral spreads should tighten again. CAC40 will probably experience a rally as big as the relief will be just after the results, but then its valuation may remain somewhat lower than in the past relative to other European markets (especially on banks and on more-domestic related stocks). The negative sentiment on the single-currency will quickly fade away as the political show and spotlights will then turn to the US.

2. A status quo assuming that the right-centrist party (Les Républicains) and the most left-centrist parties regroup together under the President Macron “La République En Marche!” banner for the 2nd round

3. The far-right secures an absolute majority

  • Cohabitation with Jordan Bardella becoming the new French Primer Minister.
  • Economic consequences remain uncertain at this stage as the definitive theoretical -and then finally applied- economic program isn’t yet perfectly clear. If the RN goes ahead with the measures they proposed since the latest Presidential elections, it will result in a net fiscal expansion (significant tax cuts and spending increases), plus some heightened frictions in the dialogue with Brussels due to their single market’s proposals and immigration restrictions.
  • In this worst-case scenario, there could be a kind of sovereign debt crisis bad taste during the summer, but with more time-and-extent-limited impacts on markets. First because there are some notable differences compared to a decade ago: ECB may intervene quickly at some point, if necessary, to ensure the proper functioning of market through the Transmission Protection Instrument; banks are well/better capitalized than in the past; growth trajectory is encouraging currently -especially in South Europe- ; EU integration has made a step forward with EU bonds with Germany more likely to compromise/help/sustain given its own internal challenges on growth, security and energy; while other developed markets -such as UK, US or Japan- aren’t immune to these debt sustainability challenges. Furthermore, some external constraints may also quickly kicking-in, in the form of the European fiscal framework, markets’ concerns amongst investors, or just risk management considerations from the Rassemblement National leaders in the run-up of the 2027 Presidential election. In this context, we can’t rule out that the RN may be forced to follow a more mainstream agenda if these external constraints matter at some point.
  • Anyway, things will deteriorate before to get better (investors will shoot first and ask questions later) with France spreads likely spiking above 100bps, Italian moving back close or above 200bps, European equities -especially France and EU banks/insurances- lagging further the US ones, and the single-currency losing some ground, especially against CHF.  

4. The Left wins an absolute majority (likely the least probable outcome)

  • Except for the name and banner of the new Prime Minister, the economic consequences and the financial markets impact are more or less the same that those depicted here above in the case of a far-right absolute majority 

Geo-political scenarios, as well as markets trajectories/reactions are by nature unpredictable and even surprising sometimes. There are however a few key elements of certainty for investors: (1) the structural problem of excessive debt is not just France’s prerogative; (2) an unsustainable fiscal trajectory increases the risk of fiscal dominance leading eventually the central banks to finance more or less directly (i.e. in a more or less subtle manner) public spending with the risk of not fulfilling its price stability mandate and thus leading to a currency devaluation; (3) another corollary is that on top of being data-dependent, major DM central banks are becoming increasingly (geo-) political developments dependent if you think about ECB, Fed, BoE or BoJ; and (4), in this context, it reinforces our conviction that Gold is likely a better safe-haven/diversifying asset than sovereign debt -especially for non-CHF based currency portfolio-.

As a result, my basic advices haven’t changed much compared to one week ago: avoid overreacting by ensuring your portfolios are well diversified (or adjust for risk-control reasons if needed); retain a great amount of caution until the final outcome (opportunities/risk premium aren’t large enough overall to compensate for the short-medium term risks at this stage, but you should start preparing a buying list); and, last but not the least, let’s also hope that French football team results and Olympics games in Paris will restore somewhat France’s luster. In some way, markets will thus also become Cocorico-dependent over the next few weeks. That’s probably the most bitter part to swallow for most European investors.

Please note this weekly letter (and his author) are taking a few weeks off. After my participation for the Swiss Team over 50y to the FIMBA Maxi Basketball European Championship in Pesaro and a few days off to recover, normal service will resume from July 15th (the day after the Euro foot final). In the meantime, I already wish you a great summer time.

Economic Calendar

While there aren’t any specific major economic releases or macro events scheduled this week, investors won’t have much time to rest either. In fact, we will get a flurry of economic activity indicators, some inflation prints and several central bank’s meeting across the major economies.

Starting with global growth, the flash June PMI readings for key economies are due on Friday: while services gauges have remained in expansion almost everywhere so far, manufacturing indices rebounded last month across most economies and are now back above 50 for the US, China, UK and Japan… but not for the Euro Area yet. France PMI will likely be in focus given the current challenging political context over there.

Turning to the US, several economic indicators will be released this week (May retail sales and industrial production on Tuesday, housing starts and building permits on Wednesday), as well as business surveys (regional manufacturing indices and NAHB Housing Market), for the latest pulse check on growth. Meanwhile, it will also be a busy week for Fed watchers with several Fed officials expected to deliver a speech and/or to make interviews in the next few days.

Speaking about central bankers and monetary policy, there will be a number of decisions to watch in Europe on Thursday with the SNB (consensus is split between a hold at 1.5% or a cut to 1.25%), the Norges Bank (staying pat at 4.25% according to the consensus) and the BoE (a dovish hold at 5.25% is expected). Central banks decisions are also due in Australia on Tuesday (no change at 4.35% from the RBA) and in Brazil (BCB Copom keeping Selic rate stable at 10.5%).

Over in Asia, the key release in China will be on the latest economic activity data for May published this morning, which were thus a mixed bag (industrial production falling short of expectations, retail sales surprising on the upside and property investment still exhibiting softness), while in Japan all eyes will be on the CPI report on Friday following a rather relatively dovish BoJ decision/stance last week. The consensus expects both headline and core annual inflation to pick up in May to 2.9% and 2.6% respectively from 2.5% and 2.2% in April.

Moving on to Europe to conclude, French politics may remain in the volatility seat for markets -especially on sovereign debt and fx- and it will be interesting to see if these recent events have impacted, and how much, the Euro Area flash PMI prints for June, which will be released on Friday. Tomorrow, there could be a first hint through the German ZEW survey. Otherwise, the latest consumer and producer prices inflation readings from the UK will be released on Wednesday, but they shouldn’t impact much BoE decision due the following day as it has never committed to an imminent rate’s cut. Note that both headline and core UK inflation rate are expected to decline to 2.0% and 3.5% respectively from 2.3% and 3.9% in April.